The Commodity Investor: Supercycle Isn't Dead; That's Why You Should Be Buying Commodities

Includes: DBO, GLD, OIL, USO
by: Hard Assets Investor

By Amine Bouchentouf

Commodity prices have corrected, making it a ripe time for countercyclical investments.

Investors in the commodities markets are going through a malaise that we haven’t seen since the late 1990s. For the first time in more than a decade, many are wondering out loud whether the “commodity supercycle” is dead. The commodity supercycle — a term coined in the early 2000s — is a theory that commodities began a long-term cyclical bull market in the 2000s.

This bull market is driven by fundamental factors including the rise of the emerging-market consumer class, increasing urbanization trends and rising incomes around the world. As a result, prices of commodities from gold to soybeans were set to rise. Recently, this theory has come under fire for not being an accurate reflection of the current state of the market.

The Supercycle

For several years, it seemed like nothing could stop commodity prices from going higher. Whether in 2008 when it looked like oil prices were going to reach $200, or in 2011 when gold prices kept making new highs as the sovereign debt crisis raged on, it seemed as if nothing could stop commodities prices from going higher.

The exuberant cheerleaders obviously took center stage, and many people began believing the hype. Those of us in the markets long enough know that markets move in cycles, and that it’s tough for something to go up in price forever. That’s why I never personally bought into the endless supercycle theory of constant rising commodity prices.

However, the case for a long-term cyclical bull market — with certain caveats — is a sophisticated theory. This theory essentially aggregates various macroeconomic and fundamental factors to explain and predict the rise of commodities throughout the economic cycle.

While we are going through the downturn of this cycle (which I will outline in the section below), this is normal; indeed, the very nature of a cycle is defined by uptrends and downtrends. What we’re experiencing right now is nothing but a downtrend.

The long-term fundamental remains intact; namely, that rising populations, growing incomes and a massive urbanization wave will create long-term sustainable demand for renewable and nonrenewable resources alike.

A Natural And Healthy Downturn

It seems you can’t turn on the news without hearing some market commentator calling for the demise of natural resources as we know them. While some of the commentary goes overboard, there are definitely major weaknesses across key commodities.

The one that’s getting the most attention is certainly gold. When you look at gold prices that reached $1,900/oz and that experienced a drop of about $600/oz over the course of several months, it’s easy to get carried away with the demise of the yellow metal. However, when you put things in perspective, you see that this is only a natural correction and — when viewed over a long-term period — is in fact a healthy and minor drawdown.

Consider 2002, when gold was trading around $300/oz. When you compare 2002 prices to the highs, you see that gold traded more than 6 times its original price when it hit $1,900/oz. Even at these prices of $1,300, gold is trading at more than 4 times 2002 prices. So when you look at it over a 10-year period, this is a minor correction.

Oil has experienced some price weaknesses that are due mostly to a disruptive technological change — the advent of “fracking” that is causing a supply glut in the market. However, oil is still trading at more than $100/bbl, and even with all the supply coming in, demand remains strong in key markets such as Japan, South Korea and China. In addition, we’re experiencing increasing demand from key emerging markets in the Middle East, Africa and Latin America that cannot be discounted.

Another commodity that’s been experiencing price weaknesses is potash. Potash prices have seen a precipitous drop recently, but that’s a result of a pricing disagreement among the “potash cartel.” The demand side of potash remains intact, except that there’s a lot of supply coming on the market and at a cheaper price. But long term, it’s likely that prices will recover in a big way.

What Smart Investors Do

No one in their right mind can claim that an asset can only go up in a straight line. As part of making new highs, it’s necessary to have corrections. What we’re experiencing right now in the commodities markets is nothing but a temporary correction. Commodities have been on a tear over the last decade and have powered through a global financial crisis, a potential European disintegration and many other economic disasters. When you look at it broadly, they’re still trading at much higher prices than they did five years ago, let alone a decade ago.

Andrew Carnegie, one of the most prominent steel investors in the 19th century, was famous for perfecting the investment process currently known as “countercyclical investments.” In a nutshell, while most of his competitors invested during boom times and therefore either lost money or saw their margins shrink during economic contractions, Carnegie only invested during downturns. This ensured that his investments were cost-effective and had the highest margins in both good times and bad.

This is the time for long-term bulls to be buying commodities of all sorts, especially the ones that have been battered. The long-term cyclical market in commodities is intact, and those that are able to capitalize while prices are at these levels are going to enjoy nice returns. The only caveat is that this investment process only works for mid- to long-term investment horizons.